While the S&P 500 is reaching all-time highs on optimism over Donald Trump's economic agenda, some Wall Street strategists are increasingly worried about a widely followed valuation measure that's reached levels that preceded most of the major market crashes of the last 100 years.
"The cyclically adjusted P/E (CAPE), a valuation measure created by economist Robert Shiller now stands over 27 and has been exceeded only in the 1929 mania, the 2000 tech mania and the 2007 housing and stock bubble," Alan Newman wrote in his Stock Market Crosscurrents letter at the end of November.
Newman said even if the market's earnings increase by 10 percent under Trump's policies "we're still dealing with the same picture, overvaluation on a very grand scale."
The Shiller "cyclically adjusted price-to-earnings ratio" (CAPE) is calculated using price divided by the index's average historical 10-year earnings, adjusted for inflation. Yale economics professor Robert Shiller's research found future 10-year stock market returns were negatively correlated to high CAPE ratio readings on a relative basis. He won the Nobel Prize in economics in 2013 for his work on stock market inefficiency and valuations.
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Other academics agreed the current extreme CAPE ratio of 27.7 is a worrying sign for future returns versus bonds.
"Only when CAPE is very high, say, CAPE is in the upper half of the tenth decile (CAPE higher than 27.6), future 10-year stock returns, on average, are lower than those on 10-year U.S. Treasurys," Valentin Dimitrov and Prem C. Jain wrote in paper titled "Shiller's CAPE: Market Timing and Risk" on Nov. 17.
Even based on the more common price-earnings ratio, the market looks rich. The S&P 500's P/E based on earnings of the last 12 months is 18.9, the highest in more than 12 years, according to FactSet.
"U.S. valuations start off as being high both on a historical basis and also on a peer group. Certainly based on the Shiller PE, the equity market seems expensive," Jefferies chief global equity strategist Sean Darby wrote on Nov. 29.
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